Has the Fed Run Out of Tricks?

It is widely, although not universally, assumed that the Federal Reserve will move in early November to bolster the economy by trying to nudge down long-term interest rates on Treasury bonds, home mortgages, and corporate bonds. Just how much rates would decline and how much production and employment would increase are uncertain. What's clearer is that the move would be something of an act of desperation, reflecting a poverty of good ideas to resuscitate the economy.

The Fed is suffering an identity crisis. Celebrated under chairman Alan Greenspan as a guarantor of prosperity, it is now struggling to regain its exalted reputation. In the acute phases of the financial panic, in late 2008 and the first half of 2009, it devised ingenious ways to provide credit to parts of the financial markets (commercial paper, money-market funds) that were being abandoned by private lenders. For almost two years, it's held its short-term interest rate near zero. All this arguably averted a second Great Depression, but it obviously did not trigger a vigorous economic recovery.

Chairman Ben Bernanke makes periodic speeches arguing that, despite lowering its short-term interest rate to virtually zero, the Fed still has ample policy tools to revive the economy and reduce the appalling levels of unemployment. The reality is otherwise; the Fed's remaining tools are arcane, weak, or both.

What the Fed is expected to authorize in November is a large purchase of U.S. Treasury bonds with the intent of driving down their interest rates, and rates on other long-term debt securities. It has already done this once. In late 2008 the Fed approved massive bond purchases; these ultimately totaled $1.725 trillion of mortgage-backed securities, U.S. Treasury bonds, and Fannie Mae and Freddie Mac bonds. Bernanke has said the program "made an important contribution" to the economic recovery.

But the measurable effects were small. A Fed study estimated that rates on all 10-year bonds might have dropped by 0.6 percentage points. The decline this time might be less, because starting interest rates are already low (about 4.3 percent for a 30-year mortgage) and the purchases might be smaller. Guesses generally range from $500 billion to $1 trillion.

Economists at Bank of America think new purchases would have "only a modest impact on the economy" but are "better than doing nothing." A plausible program might cut the unemployment rate by 0.2 percentage points (say, from 9.6 percent to 9.4 percent), says Moody's Analytics. The stock market would be slightly stronger, leading people to spend more, and a depreciated dollar would aid exports. Indeed, because Bernanke and other Fed officials have signaled a new round of bond buying, financial markets may already reflect some of these effects.

Still, there are dangers. When the Fed buys Treasury bonds, it pumps dollars into the economy. So far, this hasn't stimulated much borrowing by anxious households and cautious businesses. Outstanding consumer credit has been dropping since the summer of 2008. In part, the Fed is "pushing on a string." Banks have excess reserves of roughly $1 trillion. But if all the cheap money eventually spurred much higher economic growth, many of these reserves would turn into loans and raise the specter of higher inflation—"too much money chasing too few goods."

The Fed would then have to withdraw or neutralize the added money through higher interest rates. Adding hundreds of billions more to banks' excess reserves won't make the job easier. As important, there would be enormous pressure on the Fed not to raise rates while unemployment remains high. Economist Allan Meltzer of Carnegie Mellon University, author of a three-volume history of the Fed, fears that the Fed will—as in the 1960s and 1970s—wait too long. "Sooner or later, we'll have a big inflation," he says, "but not right away, because there's no demand now."

Economists seem split into two camps. Some, like Paul Krugman, the New York Times columnist, believe the economy is so weak that the government should do almost anything (bigger deficits, more cheap credit) that might help slightly; and others, like Meltzer, fear that expedient measures now will lead to bigger problems later. Between them, there's an unstated common assumption that there are no instant cures for the economy's lethargy. The real Fed, it turns out, is much less powerful than the mythologized Fed.